The Sinking of QE2

You’ll recall that QE2 — the fancy name for the Fed’s market manipulations — ends June 30. There is no particular reason why that date should be anything special. It’s the official end of QE2. But the market will likely anticipate the end of QE2 before it actually ends.

As Barron’s put it recently:

“Just as risk markets began to rally months ahead of the actual start last November of the Federal Reserve’s program to purchase an additional $600 billion of Treasury securities, these same markets may be beginning to anticipate the end of the central bank’s buying.”

If this holds true, then the market ought to fall as QE peters out, all other things being equal (which they never are).

There are many ways to show how the Fed is turning the market into its own personal yo-yo. The easiest way to see how the market spins up and down with a jerk of the Fed’s massive balance sheet is to plot the two against each other. When the Fed expands its balance sheet (by buying stuff, thereby putting money out there), the market rises. When it contracts its balance sheet (by selling stuff, thereby taking in cash), the market sags. Here is a chart that shows the tight correlation since the March 2009 bottom:

Whatever happens, you can rely on the herd of investors to reliably do the wrong thing. Most investors sell near bottoms and buy near tops, though that is the exact opposite of what they should be doing.

The most arresting recent statistic on this front that I’ve seen comes from Thomson Reuters’ Lipper data, which tracks money flows into mutual funds. Many investors stayed away during 2009. Even in 2010, the trickle of money heading to stock mutual funds was hardly anything.

But this past February, after the market had doubled from its lows and gained 30% since August, investors finally decided it’s a good time to go back in the market. In one week in February, investors poured more money into funds than they had in all of 2010 — about $7 billion.

A recent issue of The Economist provided an excellent illustration of how most investors do exactly the wrong thing in their timing efforts. The financial magazine produced a chart showing how investors tend to chase after the mutual funds that have been doing well, and tend to sell the funds that have been doing poorly. In general, these mutual fund investors should have done the exact opposite.

As the Economist’s story details, the funds attracting the largest amounts of new investment tended to underperform after all the money arrived. By contrast, the funds that suffered the heaviest outflows tended to outperform after all the money left!

It’s a long-held fallacy that successful investors are great market timers. Many people think that successfully predicting where the market is going to go is an important part of doing well in markets. It isn’t.
As Warren Buffett says, “Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.” He isn’t the only one to have come to this conclusion. The most successful investors I know and have studied don’t bother trying to predict the market.

In “Becoming Rich,” Mark Tier studied the investment habits of three great investors: George Soros, Warren Buffett and Carl Icahn. Tier concludes, “Successful investors don’t rely on predicting the market’s next move. Indeed, both Buffett and Soros would be the first to admit that if they relied on their market predictions, they’d go broke. Prediction is the bread and butter of investment newsletter and mutual fund marketing — not of successful investing.”

That’s why you don’t see me drawing charts with lines on them guessing where the market is headed next. Of course, it’s fun to guess what might happen, but realize these are guesses. When it comes to actually putting money to work, you ought to rely on something sterner, like good old-fashioned research on what you own.
When that process of digging around for stuff turns up fewer ideas, then you have to be willing to let the cash accumulate for a while. In my personal account, I’m up to 25% in cash. It’s just the natural outcome of my own bottom-up research.

I’ve issued a lot of “sell” recommendations this year in my investment letter, Capital & Crisis. And I haven’t added many new ideas so far. This is not a market call, but the end result of a process of buying what’s cheap and selling (or avoiding) what I think is expensive or unattractive.

So QE2 is background noise, something we have to recognize is distorting markets. But we still have to do the spadework of investing — digging around, thinking and digging around some more. Add to that a lot of patience.
One of my favorite investors was Phil Carret, who died in 1998 at the age of 101 and who worked at his art until almost the very end. He witnessed more than 30 bull markets and more than 30 bear markets over a lifetime of investing. Warren Buffett admired him, often inviting him to Berkshire’s annual meeting and calling Carret the “Lou Gehrig of investing.” (Gehrig was the “Iron Horse” of baseball, before his consecutive games played record fell to Baltimore’s Cal Ripken Jr.).

When asked on the Louis Rukeyser show in 1995 what was the single most important thing he had learned about investing over his long career, Carret had a one-word answer: “Patience.”

About Chris Mayer:

Chris Mayer is a financial analyst with Bonner & Partners. He has been quoted many times by MarketWatch and has been a guest on Forbes on Fox, Fox Business and CNN Radio, and has made multiple CNBC and radio appearances. He’s also contributed to The Washington Post. Chris travels the world looking for great ideas and insights for his readers.